Construction Lending is a Risky Business

Construction lending is inherently a risky business, even in times of stability and prosperity. During the COVID-19 pandemic, general contractors defaulted at an annual rate of 11.5 percent which was up from 3 to 5 percent historically. Contributing factors to this rise in defaults can be partially linked to cost escalations, supply chain issues, and material/labor shortages. Post-pandemic, the construction industry is still dealing with high prices and supply chain disruptions which are delaying projects and causing cost overruns all the while dealing with new market pressures such as the passing of the Infrastructure Investment and Jobs Act and a housing shortage which are adding additional obstacles to borrowers and contractors operating in the construction marketplace.

In order to reduce risk on most construction loans there is a suite of products available in the marketplace, performed by third-party due diligence companies, that can be used to identify potential issues which mitigate risks on the lending side.  These reports generated alongside a robust compliance program can produce lending guidelines that minimizes risk at all stages of the lending process.  The main products used industry-wide include a Plan and Specification Cost Review, Draw Inspections and Property Condition Reports.

What Is a Plan, Specification, and Cost Review (PCSR)?

A Plan and Specification Cost Review (PSCR) is an evaluation of pertinent documents utilized during the construction of a project.  The documents reviewed include but are not limited to: stamped drawings, complete budget, schedule, environmental reports, geotechnical reports, constructor contract, design contract, survey, utility will-serve letters, municipal approvals, and project specifications. Each document is thoroughly examined to identify potential risks to the lender and summarized to make understanding the information easy for lenders of all aptitudes.

What Is a Draw Inspection?

Loan proceeds are generally disbursed over the course of the construction project in installments called draws. In order to fund a draw, most lenders require verification work has been completed for the funds being requested.  This is done by providing a visual inspection of the work completed onsite and comparing the requested amounts to the invoice provided.

While billing approval is the main focus of a draw inspection, several other items are analyzed to ascertain the overall health of the project.  These include schedule progression, change order analysis, potential change order detection, lien waiver review and permit tracking.  Paying attention to these indicators can often head off future issues such as overspending, depletion of funds and schedule fade.

What Is a Property Condition Report?

Either prior to renovating an existing building or during the sale of an existing structure, knowing the current condition of the collateral is key to a successful lending transaction.  A property Condition Report (PCR) is an industry-standard compilation of current conditions of the key building components observed during a thorough field inspection.  Some of the components inspected include: HVAC equipment, plumbing systems, electrical systems and equipment, roofing, exterior façade, doors and windows, etc.

Identifying the current conditions of these components allows for a financial analysis (12 year capital reserve) to be performed on issues identified during the field inspection.  This financial analysis provides estimated maintenance and repair cost for each item that has degraded to the point of failure or exceeded its effective useable live (EUL).  This information is summarized in multiple formats that allows the end user a condensed aggregation of the information necessary in making lending decisions.

Stay Tuned…..

Most lenders encounter the same issues on each construction loan such as increased project cost or delay in project completion.  Future blogs will analyze these issues and dive deeper into the previously identified products, details in how to properly use the report and pitfalls the industry falls into when using these products.

And as always….

LCS listens to your needs to develop products that are right for your transaction. Whether that be an individual appraisal, environmental/construction report, or a combination of services; LCS will meet your needs in the most efficient, effective way possible.

To learn more, reach out to Liz Mahoney, Director of Sales & Business Development today.

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